Money Metrics: Return on Investment Analysis
Return to Sender
We’ve covered a few different techniques to connect your money to your decision making this week. No discussion of money metrics would be complete without covering the all important Return on Investment (ROI)! So, let’s cover that today.
Every business decision you make is really an investment. Perhaps you are investing money in hiring new staff, spending your time on pursuing a new partner (time is money), or spending money on advertising to recruit new customers. Whatever decision you are making, you need to understand if you get a return on that investment. Did that new hire generate more value than the cost of their salary? Was the new partner worth the amount of time it took, which you could have spent elsewhere? Did the advertising you did work?
In some ways ROI is the simplest metric we’ll cover, as it simply asks:
How much did you make from a given investment?
For example, if you hire a salesperson who costs you $60,000/year (an investment) and they bring in $70,000 of new business (net revenue) then there is a positive return on your investment in that person. If that same salesperson only brings in $40,000 of new business (net revenue) then you are losing money on that investment.
It might seem simple, but it can be hard to calculate for a few reasons:
- You make dozens of decisions for your business everyday. It can be hard to judge which returns are attributed to which decisions and properly allocate returns.
- It may take years (or decades, in the case of buildings) for an investment to produce a return. Over that period your business will change and you may lose track of the individual investments.
Because of these reasons, calculating ROI often involves more art than science. It can be abused, fairly easily, to justify questionable decisions and investments, or easily miscalculated. As with many aspects of using data, the hardest part is the people interpreting the data.
The best way to protect yourself against biased ROI calculations is to make sure that whoever is determining the return has no incentive to mislead. If I made an investment and my job is measured by whether it produced a return, I’m more likely to find one in the data! This is one of many reasons that having an independent finance group is so important for larger companies.
We’ve covered a lot of money metrics this week, and I hope you find at least a few of them useful in running and growing your business. Next week we’ll discuss setting goals and how data driven goals can either be a powerful weapon or a horrible burden.